STEVEN PEARLSTEIN

Bank regulators once bamboozled, now emboldened

The encouraging news out of Basel, Switzerland, is that the world's bank regulators are finally getting their spines back.

Until the financial crisis exposed their gullibility, the regulators had been bamboozled into believing that banks could pretty much decide for themselves how much capital they needed to set aside as a cushion against possible loan losses. Over the years, the ratio of capital to total assets had been allowed to fall from 8 percent of assets to somewhere between 2 and 4 percent. Under the Basel II standards, championed by the Federal Reserve under Alan Greenspan and Ben Bernanke, the bankers had been on the verge of pushing it down further.

The new rules agreed to last weekend bring the capital requirement back up to 7 percent, with even more required from the very biggest banks and an extra surcharge that kicks in the next time bank lending grows faster than the underlying economy.

With U.S. banks now chastened and hoarding cash, the new rules aren't likely to pinch much for a while, but rest assured that Wall Street is cooking up the next wave of financial innovation to circumvent the rules. The trillion-dollar question is whether regulators have learned from the last credit bubble the lessons necessary to prevent the next one.

To answer that question, I sat down with the top career supervisors at the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., who were refreshingly candid about how and why their agencies had failed to head off the crisis.

I think we can be fairly confident that the regulators no longer believe, as Greenspan once did, that bank executives always know what is in the best interest of their own banks, and that to the degree that they don't, the market can be relied on to discipline them. They have also lost confidence in the sophisticated risk-management systems that never questioned the wisdom of 72-month car loans, or loans to subprime borrowers with undocumented incomes or commercial real estate deals premised on returns lower than riskless Treasury bonds.

Regulators claim that they now see the folly of their over-reliance on market indicators, such as quarterly profits or current asset values, in assessing the financial health of a bank or the quality of its loans. Supervisors have been told to be more forward looking in their analysis and less optimistic in their assumptions about future profits and prices. Particularly for the larger institutions, the focus now is as much on the overall business strategy of the bank as it is on a review of the loan book.

"The challenge is: How do you institutionalize skepticism?" said Dan Tarullo, the Fed governor and onetime critic who is now spearheading a top-to-bottom overhaul of the Fed's bank supervision.

The regulators acknowledge they had a poor understanding of the more arcane new instruments that banks were creating and using, such as synthetic CDOs and naked credit-default swaps. They also had no idea of the size of those markets or how they might interact with each other. To my ears, those were surprisingly candid and embarrassing admissions. To make sure it doesn't happen again, Tarullo has added economists and capital market experts to its bank examination teams.

At the same time, regulators were quick to point out that front-line examiners were well aware of other questionable practices as early as 2004 and took steps to try to curb them. According to Deputy Comptroller Tim Long, however, those steps proved to be too little and came too late to avert the crisis.

Back during the boom, for example, Long said his examiners "raised hell" about overly risky consumer and commercial real estate loans, only to be pushed back by the bankers who explained it didn't matter because the loans were about to be packaged and sold off to hedge funds and other investors. These days, Long says his examiners require that banks adhere to their own underwriting standards even for loans they intend to sell.

That's the right policy response, of course. What's less clear to me is whether the supervision process remains so bureaucratic, legalistic and vulnerable to political blowback from the industry that the next time examiners run into some shoddy practice, the response once again will be too little, too late. What you'd like to see is the regulatory equivalent of that big red button they have in Toyota plants that any worker can push and stop the assembly line when he sees a quality problem.

One reason that doesn't happen, I suspect, is the culture of secrecy and obfuscation that has grown up around bank regulation. Because the first obligation of a bank examiner is to prevent bank runs, they are reluctant to publicize the shoddy practices of any individual bank or even the industry in general. And over the years, banks have used this preference for doing things in a hush-hush manner to their advantage. Tarullo says he'd like to have more public disclosure of supervisory information that would expose risky practices to more public and market pressure call out the bad actors, but there is nothing close to consensus on that one.

In the end, however, the biggest challenge facing regulators comes not from traditional banks but from the shadow banking system that now provides more than half of the credit to American businesses and consumers, that was the source of most of the problems that lead to the financial crisis and that and remains largely out of the reach of the regulatory apparatus, even after passage of the financial regulatory reform legislation.

While a bank, for example, will now have to set aside capital equal to 8 percent or more of its outstanding loans, there is still no capital required for similar loans that might be originated by a group of finance companies, bought up and packaged by an investment bank and sold off to hedge funds and wealthy investors. It was this world of swaps and repos and CDOs that confounded regulators the last time. The danger is that as the regulation of traditional banks becomes more stringent and, one hopes, more effective, it may end up driving even more of the lending business through the shadow banking system.

It will require a wily and aggressive new breed of regulator to prevent that.